Our Perspective.
The Federal Reserve set the tone for the ‘higher-for-longer’ narrative late in September. Alongside higher oil prices, both US fixed income and equity markets took this as a negative and we saw a meaningful correction in the last two weeks of September.
US Treasuries are typically seen as a safe-haven asset when equities struggle so the recent market correction presented a major concern. It’s rare that we see US equities sell-off alongside a major bear-steepening in the US Treasury curve, especially to the extent we saw. A bear-steepening is where we see higher US treasury yields, with yields at the long-end rising more than that of the short tend.
What one would typically expect is that a sell-off in US equities is accompanied by rising uncertainty. Long term growth expectations are a primary factor in long dated US treasuries, and higher uncertainty would typically lead to lower growth expectations, and lower long dated yields. So, we ask ourselves, what has changed?
There are three key components to long-dated US treasury yields:
- Inflation expectations
- Growth expectations
- Term premia
The first two are really a function of monetary policy, that is, expectations of Fed policy. In September, inflation and growth expectations have effectively offset each other. That leaves term premia – which was the primary driver in the sell-off of US treasuries in September.
The term premium can be seen as the compensation investors require in order to bear the risks of changing interest rates over time. That means it has much more to do with expectations of future treasury demand and quality, as opposed to monetary policy and inflation or growth.
The real risk to the US economy and financial stability is that capital market lose faith in the quality and reliability of the US Treasury market. That will lead to a structurally higher term premium. The recent downgrade, rising risks of a government shutdown, and the need for more issuance in the future are all factors.
But if weak economic data doesn’t result in falling long-term interest rates, the US has a problem. Structurally higher rates will have a very negative impact on both corporate and consumers, and the risks of a hard landing are intensifying.
This also highlights the risks in the 60/40 portfolio, and the need to investors diversify their portfolios. Structurally higher rates mean structurally higher risk and will lead to poorer returns in fixed income markets, and lower multiples in equity markets.
Our recommendation to investors is to diversify their portfolios. Protect against monetary devaluation, volatile inflation, structurally higher risk and subpar growth. This is what our portfolios offer!
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